VIG – Your Best Way to Navigate Rockier Waters in 2014

Editor’s note: This column is part of our Best Stocks for 2014 contest. Brendan Conway’s pick for the contest is the Vanguard Dividend Appreciation ETF (VIG).

best-stocks-for-2014-VIGThe big temptation in a stock-picking contest is to aim high. YOLO!

Well, I’m going to channel Dana Carvey instead. Not gonna do it. Wouldn’t be prudent!

My pick is staid and, as it happens, not even a stock: Vanguard Dividend Appreciation ETF (VIG). It’s not an aggressive pick, so I’ll hopefully be ahead of the can’t-lose stock which drops 20%, or the busted momentum stock that’s down 40%. Depending on my competitor’s picks, I’ve got a shot to win, though I frankly think a pick that just gets hot is likely to outgain me.

As a person whose instinct is to distrust my own picks, that’s OK by me. Here’s a look at the reasoning.

Start with the obvious: The stock market is coming off a blowout year. The S&P 500 is ahead by 27%! It’s been an amazing year. Given that recent success, a risk-averse investor should be just as preoccupied with preserving gains as adding to them.

If you’re still with me after this bit of risk aversion, let’s take a look at what happens after a 27% gain.

Answer: A lot of things, most of them good.

But not all of them.

The stat from S&P Dow Jones Indices: A sharp rise in the S&P 500 has been followed by a rising market once again roughly four out of five times since 1945. Sounds great! But hold on.

I recently spoke on the subject with Brian Mackey of Adviser Investments, who studied every 12-month period in the stock market since 1976. Mackey’s bigger, more robust data set shows gains as high as 42.9% and losses as steep as 18.3% (and more gains than losses, so count that in our favor).

“Saying the next year is usually a gain,” Mackey observed for my most recent Barron’s column, “is like putting your head in the oven and your feet in the fridge and declaring, ‘On average, I’m pretty comfortable.’”

I’m not going to argue that stocks are headed for an 18% loss during 2014, but I will argue it probably won’t be as good a year as 2013 — and likely more volatile. Suppose we do have an 18% loss, though. You would have wiped out 85% of your stock portfolio’s remarkable 2013 rise. A smaller loss would wipe out half.

This leads to the key point: The importance of avoiding big losses. It’s math. A 10-percentage point drop from $1,000 hurts more than a 10% rise from $900 helps.

Why You Should Buy the Vanguard Dividend Appreciation ETF (VIG)

The key reason I like this Vanguard ETF — which screens for big, quality companies with a 10-year history of dividend increases — is its favorable risk-adjusted returns. The VIG has captured most of stocks’ upside, but with significantly smaller declines, meaning smaller losses. In this year of interest-rate worries, it has worked quite well. VIG is ahead by 24%, which is only a smidgen behind the S&P.

How did VIG fare during the 2008 bloodbath? A 26.5% drop. This turns out to be almost exactly the loss in the industry that touts itself as protecting you from declines — hedge funds. And notably smaller than the S&P’s 37% decline.

So we’ve seen a good result in bullish 2013 and a better-than-average result in bearish 2008, when the Vanguard ETF’s components kept increasing dividends straight through the crisis. Suppose 2014 is more like 2011, a volatile year when the S&P rose by 2.1%. The ETF back then outperformed, too, gaining 6.2%.

The intuition is something like this: You’re investing in quality companies with strong balance sheets which are capable of weathering rough markets. But they’re not stodgy old dividend-centric companies so much as growing firms which choose dividends as a means of rewarding shareholders, such as Abbott Laboratories (ABT) or Lowe’s (LOW).

What about risks specific to 2014, like interest rates? Yield hogs got slaughtered during 2013. A dividend-growth strategy isn’t about current income, though. The Vanguard ETF sold off a little during the mid-2013 rate scare and recovered.

Valuations look better than average. At a time when many “defensive” stocks are proving richly priced, VIG’s portfolio trades for 15.8 times next year’s earnings, which is less than the S&P 500.

In short, buying VIG is an idea for an investor who…

  1. Thinks stocks are still the best opportunity in town.
  2. Thinks there are better-than-even odds of stocks rising during 2014.
  3. Thinks it will be a rockier ride than 2013.
  4. Is willing to settle for a middling result.
  5. Wants to stack the odds against a steep loss.

Bottom Line

I was tempted to go international with this idea. In that case, I would have selected the FlexShares International Quality Dividend Index Fund (IQDF), which has trounced other global-stock indexes in its short history.

However, I’m sticking with America’s VIG for the Best Stocks for 2014 contest on the idea that U.S. stocks are reasonably priced, the country isn’t heading into a recession and the market will handle a stingier Fed with aplomb.

As of this writing, Brendan Conway did not hold a position in any of the aforementioned securities. More of his writing can be found at Barron’s Focus on Funds blog.

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